Morgan Stanley’s step notes linked to Stoxx Europe 600 Banks show high volatility, high upside

By Emma Trincal

New York, July 25 – Morgan Stanley Finance LLC’s 0% trigger step securities due July 31, 2020 linked to the Stoxx Europe 600 Banks index offer an attractive structure, but the underlying investment theme is “too narrow” and risky as large European banks represent a volatile sector in an already volatile geographic area, buysiders said.

If the index finishes above its initial level, the payout at maturity will be par of $10 plus the greater of the index gain and the step return of 51% to 61%, according to an FWP filing with the Securities and Exchange Commission.

If the index falls but finishes at or above its downside threshold level, 70% of the initial level, the payout will be par. Otherwise, investors will be fully exposed to any losses.

Alpha

“I have no issue with the structure. It looks fine actually,” said Jerrod Dawson, director of investment research of Quest Capital Management.

“You have the step that boosts your upside and no cap if the index does more than that, which lets you participate all the way.

“If you’re looking for [a] high-volatility, high-upside type of play, the structure looks pretty good. It offers a lot of alpha opportunities.”

Volatile space

However, Dawson said that he does not want to be in that “space,” given the volatility of the underlying index and the issues seen in Europe, especially around Brexit and banking.

“If you look at the global macro picture, Europe is a little bit unsettling. The U.K. has to go through the process of leaving Europe. ... Some banks have some issues. You really have to believe in central banks and Mario Draghi’s too-big-to-fail policy. But I’m a little bit skeptical. I’m sure we’ll see a lot of hiccups with Brexit,” he said.

Draghi is the president of the European Central Bank.

“While I like the structure, you still have a big downside risk. Thirty percent on the downside is a big cushion only if you are optimistic about this bet. We think it’s a bit too volatile. It’s also too granular for us. We usually look at broader benchmarks.”

Digital jumps

Steven Foldes, vice-chairman of Evensky & Katz/Foldes Financial Wealth Management, said he likes the step-up structure in general but not this note.

“These digital jump notes are products we’ve paid particular attention to over the past six to 12 months,” he said.

“The traditional leveraged buffered notes have become increasingly less attractive. We can no longer find the pricing we enjoyed after the Great Recession.

“The idea of getting a digital jump even if the asset class is up by a fraction is really attractive.

“If you believe the market growth is going to be modest or range bound, this is something interesting which has caught our attention as a firm.”

His firm bought two such products recently.

“We like it conceptually,” he said.

Tenor

But this particular note does not meet his expectations for several reasons.

“First, four years is a long time. You don’t get paid dividends during that time,” he said.

The Stoxx Europe 600 Banks index yields 3%.

“You’re giving up 12% over the length of the notes, which is a significant amount of money,” he said.

A longer tenor has another disadvantage: it increases credit risk exposure.

“Obviously you’re dealing with the credit quality of Morgan Stanley. We’ve done business with Morgan Stanley, but with structured notes the credit quality of the bank is always a concern,” he said.

One of the appealing aspects of the product is the upside.

“Obviously, 51% to 61% is not a bad result. It’s also nice that it’s uncapped. That’s an attractive feature in this note,” he said.

Barrier

But the barrier is disappointing.

“Given how volatile this index is – it has already lost nearly 40% in a year – I would opt for a lower buffer,” he said.

“One would think that over four years, a 70% barrier is significant. But we prefer absolute protection in the form of a buffer.”

In his view, a 15% to 20% buffer would be more appropriate than the 30% of contingent protection.

Sector-specific

Finally, Foldes said he prefers broader indexes when investing in structured notes.

“From our perspective, we tend to stay away from a very narrow, specific sector such as European banks. We would opt for larger segments of the market, for instance international developed markets or emerging markets. We just prefer broader benchmarks.”

The exact step return will be set at pricing.

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent. UBS Financial Services Inc. is the dealer.

The notes are expected to price Wednesday and settle Friday.

The Cusip number is 61766B739.

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